Capital Openness and Income Inequality: Smooth Sailing or Troubled Waters?

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The 2008 Global Financial Crisis and subsequent financial turbulence has triggered economists and policymakers to revisit the extent to which capital account liberalization is optimal for all countries at all levels of development. Liberalization is a positive step for financial development as it can increase risk-sharing within the domestic economy and smooth out domestic consumption, thus increasing financial stability. However, when financial institutions are weak and access to credit is highly exclusive, liberalization may bias financial access to higher-income individuals and increase income inequality.

In a working paper, Guillermo Lagarda, Jennifer Linares and Kevin P. Gallagher examine the distributional consequences of capital account liberalization for a large panel of countries to weigh the impacts on income inequality.

The authors conclude that capital openness decreases inequality when a country transitions into a higher income group. Financial development through building stronger institutions works to extend the benefits of the capital account liberalization to all income levels and balance financial success across all income groups.

The paper recommends several policies that would implement protective measures for disadvantaged groups and provide a buffer to potential income inequality. For instance, countries can pursue policies that aim to seize the positive spillovers of openness during economic expansion, albeit designed such that they can also act as safety nets during contractions. For countries with weaker social safety nets, the paper’s findings propose resorting to capital restrictions during economic downturn to check runaway income inequality and ensure fairer economic distribution.

Read the paper